Monday Morning Notes: Fed Week

The big financial event of the week comes Wednesday when the Fed reveals the outcome if the FOMC meeting, followed shortly by a new Summary of Economic Projections and Chairman Jerome Powell’s press conference. There may be only a handful of us still interested in monetary policy by the time Wednesday comes around; Rosenstein and Kavanaugh are sucking the oxygen out of the room. Arguably not a bad thing as the economy is not really the nation’s biggest current challenge.

My view of the FOMC outcome is over at Bloomberg, where I conclude:

Fed Chairman Jerome Powell and his fellow policy makers remain primarily focused on a domestic economy that holds substantial momentum as the fourth quarter approaches. At best, the message from the Fed is neutral relative to the June SEP report and press conference. The risk, however, is that the Fed’s message is on the hawkish side, including an upward shift at the lower end of rate projections that doesn’t necessarily imply a faster pace of hikes, but more confidence that the gradual pace of increases will extend deep into 2019.

The message delivered by the FOMC will tend modestly toward hawkish this week, firming up expectations that the Fed will press on for longer than markets  anticipated just a few weeks ago. For what it’s worth, recently the market participants have had to catch up to the Fed rather than vice-versa. This tends to be the case during the mature phase of a business cycle.

The Fed may drop the phrase “policy remains accommodative” because of the wide range of estimates of neutral policy.  Policy might in fact be close to neutral. But Federal Reserve Lael Governor muddied the waters further by differentiating between short and long run neutral rates; in her framework, policy in the short-run clearly remains accommodative. So maybe they keep the phrase. In addition, the Fed could retain the language because they fear its removal would be taken as a sign that of an imminent policy pause. My thinking is that if they remove the “accommodative” language, we should not interpret that removal as dovish, a point that I think will be evident in the SEP and Powell’s press conference.

The reason the Fed continues to press on with the rate hike campaign is quite simple – the economy refuses to catch a cold, let along give up the ghost. As long as that is the case, the Fed will continue to ratchet up the pressure with gradual rate hikes. To be sure, there is plenty to worry about. Trade wars. Oil prices. Emerging markets. Political crisis in the U.S. It is reasonable to be concerned that these factors will eventually cause a real dent in the U.S. economy, but so far the economy and financial markets have remained remarkably resilient to these threats. Consequently, they remain risks to the outlook but do not materially effect the Fed’s outlook in such a way that would trigger a Fed pause.

Bottom Line: Eventually the Fed will stop hiking interest rates. But that time will likely not come in 2018. And even an extended pause might have to wait until the second half of 2019.

FOMC Preview: Any Tilt In The Outlook More Likely Hawkish than Dovish

My latest on Bloomberg:

Most every market participant expects the Federal Reserve to raise interest rates another quarter percentage next week, the eighth increase since December 2015. And despite speculation the central bank may be close to slowing the pace of hikes, the reality is that while any changes to the Fed’s Summary of Economic Projections would be modest, they would likely reveal a more hawkish than dovish tilt…

Continued at Bloomberg Opinion.

Monday Morning Notes: Blackout Week

Data last week gave little reason to suspect that monetary policy would soon deviate from the current path of gradual rate increases. Tame inflation continues to hold the pace of rate hikes to “gradual.” Still, the Fed will resist ending rates hikes until they have good reason to expect growth will slow to a range they believe consistent with stable inflation. That will make for interesting debate if growth remains strong as the policy rate approaches 3%. Still that is a story for later. The immediate future holds yet another rate hike.

Industrial production told a familiar story – the nation’s factories hum a long, powered by solid underlying demand:

Retail sales were on the soft side in August, but prior months were revised higher:

Still, the upward trend of core sales is the best experienced during this cycle. Whenever you hear of a threat to household spending, it pays to remember that the U.S. consumer will not go quietly into the night.

Although the economy looks to be holding onto the momentum of the second quarter (the Atlanta Fed currently pegs growth at 4.4%), inflation remains under control. Core-CPI inflation plummeted on a monthly basis, pulling the year-over-year numbers lower:

It’s numbers like those that keeps the Fed locked into a gradual pace of rate hikes. The Fed might believe that the current pace of growth will eventually prove inflationary hence preemptive hikes remain necessary. But at the same time, inflation doesn’t provide a reason to step hard on the breaks. That said, the unusually weak goods inflation (apparel and medical goods commodities) pulled the overall August inflation number lower:

On the services side, medical care was a drag. I suspect this weakness will prove to be temporary. I would be wary of expecting a sustained downturn of inflation at this stage of the cycle and I am hesitant to expect a sustained declined in health services inflation. Still, whatever behavioral switch that triggers worrisome inflation dynamics appears to remain in the “off position.”

Fedspeak will be nonexistent this week, blacked out in advance of next week’s FOMC meeting. Sadly, only a few data releases will entertain between now and then. Most important will be housing data (starts and permits Wednesday, existing home sales on Thursday). We will be watching for indications that housing activity could be a moderating factor on economic activity. Enough such factors and the Fed could see the data that support a sustained policy pause in the first half of next year. But as I have said before, that is still more hope than reality.

Bottom Line: Quiet week as we await next week’s FOMC meeting.

Fed Debate on Neutral Rate Misses the Bigger Picture

First, “What’d You Miss” Bloomberg interview with Joe Weisenthal:

Link here if video not working.

Second, new Bloomberg column:

Federal Reserve policy makers are debating whether to stop tightening monetary policy when interest rates reach a neutral level that neither stimulates nor restricts growth. At this point, there is no easy answer, but central bankers should de-emphasize the level of rates at which they would pause and instead focus on the economic conditions that justify a pause.

Continue reading on Bloomberg Opinion.

Finally, recent data tells a familiar story with contained inflation and strong growth. Calculated Risk reports some recent estimates placing third quarter GDP growth in a range from a low (New York Fed) of 2.2% to a high (Atlanta Fed) of 4.4%. Assuming the reality splits the difference at 3.3%. That is a growth rate that easily keeps the Fed hiking, but the inflation numbers moderate the pace of hikes to the Fed’s gradual path. The status quo holds.

I will have more on the recent data flow Monday. Until then, have a great weekend!

Brainard To Markets: We Aren’t Stopping At What You Think Is Neutral

Federal Reserve Governor Lael Brainard delivered a clear message in her latest speech: The way things are going, the rate hikes are not going to stop anytime soon. In fact, you should be happy that we haven’t accelerated the pace of hikes. As I said earlier this week, the “pause” story is more about hope than reality. We can’t talk pause until we detect a significant change in the tone of the data.

The theme of Brainard’s speech is an explanation of the neutral policy rate with an eye toward policy implications. It is tempting to say that market participants are the intended audience. I sense this is too narrow. I think this is also a message for her colleagues at the regional banks who argue for a pause at neutral. She is telling them they don’t understand what neutral means. Or at least they need to be more careful about its meaning.

So what does neutral mean? Brainard:

Intuitively, I think of the nominal neutral interest rate as the level of the federal funds rate that keeps output growing around its potential rate in an environment of full employment and stable inflation.

Right – this would be a standard definition. But Brainard wants to emphasize the difference between the short- and the long-runs. First:

Focusing first on the “shorter-run” neutral rate, this does not stay fixed, but rather fluctuates along with important changes in economic conditions…In many circumstances, monetary policy can help keep the economy on its sustainable path at full employment by adjusting the policy rate to reflect movements in the shorter-run neutral rate. In this context, the appropriate reference for assessing the stance of monetary policy is the gap between the policy rate and the nominal shorter-run neutral rate.

Read that carefully. Brainard says that at a full employment economy (like now), the shorter-run neutral rate is the relevant indicator for determining the level of accommodation provided by a particular policy stance. By extension, in the current situation, the longer-run rate is not the relevant metric. In other words, policy might still be accommodative even when pegged at the longer-run neutral rate. Don’t look at the longer-run SEP rate estimates to assess the current policy stance.

We all know the estimates of the longer run rate, 2.5-3.5% as reported in the SEP. So what is the shorter-run neutral rate? Back to Brainard:

Turning to the shorter-run neutral rate, although the estimates are model dependent and uncertain, we can make some general inferences about its recent evolution that are largely independent of the details of specific models. Estimates suggest the shorter-run neutral rate tends to be cyclical, falling in recessions and rising during expansions, and our current expansion appears to be no exception.

Take a moment and appreciate Brainard’s intelligence and foresight. She doesn’t provide a number or even a range. Why not? She has estimates. She just said so. Brainard wisely does not provide that estimate because she knows we will lock onto that number and will not let go. She doesn’t want to lay down that marker because she knows it can change all too easily.

Brainard doesn’t give you a number, but she still gives guidance. That guidance is all about the data:

Last year, the unemployment rate returned to pre-crisis levels, which required real interest rates that were below zero for nearly 10 years. This year, the unemployment rate has fallen further, and job market gains have gathered strength, at the same time that the federal funds rate has increased. This combination suggests that the short-run neutral interest rate likely has also increased. If, instead, the neutral rate had remained constant as the federal funds rate increased, we would have expected to see labor market gains slow. That inference is consistent with the formal model estimates, which indicate that the shorter-run neutral rate has gone up as the expansion has advanced. This is also suggested by the observation that overall financial conditions, as measured by a variety of indexes, have remained quite accommodative during a period when the federal funds rate has been moving higher.

The Fed has been raising interest rates, but that “tightening” has yet to be felt in the economy. Au contraire, the job market has strengthen in recent months and financial conditions remain loose. So it must be that the short-run neutral rate has risen – and arguably risen more than policy rates, which would account for the stronger job market. This, by the way, is what I think the Fed should be doing – talking less about the neutral rate estimates and more about the data. It’s the future of forward guidance.

With some guidelines on the kinds of data we should be looking at, Brainard shift to a discussion of the outlook. It’s an optimistic forecast: “…it seems likely that growth will remain solid.” And while she also shows some mild optimism that there remains room for addition improvement in labor markets, Brainard is clearly concerned about the stability of the inflation outlook:

At 3.9 percent, the August unemployment rate was about 1/2 percentage point lower than the previous year. If unemployment continues to decline at the same rate as we have seen over the past year, we will soon see unemployment rates not seen since the 1960s. Historically, the few periods when resource utilization has been at similarly tight levels have tended to see elevated risks of either accelerating inflation or financial imbalances…So far, the data on inflation remain encouraging, providing little signal of an outbreak of inflation to the upside, on the one hand, and some reassurance that underlying trend inflation may be moving closer to 2 percent, on the other…The past few times unemployment fell to levels as low as those projected over the next year, signs of overheating showed up in financial-sector imbalances rather than in accelerating inflation. The Federal Reserve’s assessment suggests that financial vulnerabilities are building, which might be expected after a long period of economic expansion and very low interest rates.

She apparently takes little relief from the stable inflation numbers to date, instead fearing a reprise of inflation or financial instability episodes of the past. And arguably the latter are currently the more relevant concern! What that means for policy is that the rate hikes keep coming:

Over the next year or two, barring unexpected developments, continued gradual increases in the federal funds rate are likely to be appropriate to sustain full employment and inflation near its objective. With government stimulus in the pipeline providing tailwinds to demand over the next two years, it appears reasonable to expect the shorter-run neutral rate to rise somewhat higher than the longer-run neutral rate. Further out, the policy path will depend on how the economy evolves.

No reason to pause at the longer-run neutral rate because that will not be shorter-run neutral. So what about all those Fed regional presidents talking about pausing at the longer-run neutral rate? Maybe we shouldn’t be paying too much attention to them.

Brainard repeats her yield curve story. The summary is that yes, she is aware of the historical implications of the yield curve, but this time is different so it is not an impediment to raising rates. Brainard also throws in the obligatory “data dependence” caveat, but it is clearly biased in a hawkish direction:

While the information available to us today suggests that a gradual path is appropriate, we would not hesitate to act decisively if circumstances were to change. If, for example, underlying inflation were to move abruptly and unexpectedly higher, it might be appropriate to depart from the gradual path. Stable inflation expectations is one of the key achievements of central banks in the past several decades, and we would defend it vigorously.

As I keep saying, the Fed is going to pick recession over inflation. That isn’t changing.

Bottom Line: The rate hikes are going to keep coming until it becomes more evident that growth will ease to what the Fed believes is a more sustainable pace. Don’t count on an automatic pause as rates approach 3%. And don’t expect the Fed to care about the yield curve if the data continues along its recent path.

Monday Morning Potpourri

Click here for newsletter version!

First, an excerpt from my latest on Bloomberg Opinion:

The Federal Reserve this month is widely expected to raise interest rates for the eighth time in the current hiking cycle that began in December 2015. Get ready for tensions within the Fed to spill over into the public as monetary policy moves closer to estimates of the neutral rate.

The Fed staff will likely push harder for policy makers to follow a model-based approach with fairly hawkish implications that would result in rates rising beyond what is considered a neutral level. Although Fed Chairman Jerome Powell doesn’t look married to the Fed’s models, he hasn’t provided a great deal of alternative guidance. That means policy will become less predictable in 2019.

Second, that said, policy is pretty predictable for the rest of this year. The Fed will hike rates in September, they will most likely hike rates in December, and at the December meeting they will likely signal they are not yet ready to pause. The continued strength of the US economy provides the simple reason the Fed will push forward with rate hikes in the near term. Indeed, the August labor report provides more evidence that the economy continues to charge forward despite the uncertainties induced by the Trump Administration.

Firms added 201k employees to their payrolls in August, pretty much the same pace as the last three months and the last twelve months. The unemployment rate held steady at 3.9%; the number of unemployed fell but the number of persons in the labor force did as well. The labor force participation rate continues to hover in a familiar range. The Fed will see this as reason to believe that the pace of job growth remains sufficient to push the unemployment rate still lower, keeping fears of overheating alive.

Attention fell heavily on the wage number as average wages rose to a cycle high of 2.9% year-over-year. This extends the trend of slow but steady increases in wage growth and will provide the Fed reason to believe that the economy is working as it should.

Note that the wage gains shouldn’t really be a surprise – wages had to rise to keep pace with inflation. Using core-PCE as a deflator (which I think it more appropriate than headline because it likely more accurately reflects expectations and abstracts away from some wild swings in recent years), real wage growth is hovering around its pre-recession level, say 1%, probably not too far from trend productivity growth.

A baseline expectation is that in a normal labor market, wage growth will be in the vicinity of real wage growth plus inflation (on average, headline and core inflation are very close over time). Assuming trend productivity remains constant near 1%, further labor market tightness should yield one of two outcomes – either real wages rise at the expense of profits margins or nominal wages and inflation rise in a lockstep pattern. The Fed would likely welcome the first outcome but would be unhappy with the second.

Looking forward, temporary help payrolls guide us to anticipate continuing overall job growth. It ain’t over yet – and that’s what keeps the Fed hiking until they get closer to their estimates of neutral policy.

Third, a little Fedspeak last Friday. Dallas Federal Reserve President Robert Kaplan said the job report confirms what I just said above. Via Fox Business:

“That tells me that over the next nine to 12 months, we ought to be raising the Fed fund rates probably at least three more times, maybe three to four times, to get to that neutral rate,” Kaplan said during an exclusive interview with FOX Business’ Edward Lawrence. “Everything that’s in this job report today just causes me to reaffirm that view.”

Kaplan doesn’t think trade concerns are materially impacting the economy yet and thus doesn’t provide a reason to pause in the near term. He also says that the fiscal stimulus will fade over the next two years and that he is watching for how demographic shifts expected to weigh on labor force growth will impact the economy over the next two years. Note that Kaplan has in the past stated his preference for a neutral-then-pause strategy.

Separately, Cleveland Federal Reserve President Loretta Mester described the jobs report as strong and justifying continued gradual rate hikes to push policy to a neutral level (see Bloomberg here). She adds that the economy has more “underlying momentum” than she believed in June. Watch for the impact of stronger growth on the “dots.” While we are all looking for the pause, maybe some of the Fed anticipates more rate hikes than currently expected.

Chicago Federal Reserve President Charles Evans released a speech originally prepared for his cancelled appearance in Argentina (never waste good copy!). After describing the economy and policy as returning to something more normal, the dove turns to a hawk:

Given the outlook today, I believe this will entail moving policy first toward a neutral setting and then likely a bit beyond neutral to help transition the economy onto a long-run sustainable growth path with inflation at our symmetric 2 percent target.

Yep, this is what the models are telling them to do. This will be the crux of the debate next year as the models demand more tightening. What I find most interesting is the adherence to these models even though, as Evans says, they will sustain the economy in the zone where the zero lower bound is likely to be an issue once again. One would think the Fed would continue to adjust policy accordingly in a dovish direction but increasingly is looks like many policymakers intend to 1.) fall back on old models and 2.) accept the likelihood of a return to the zero bound and be ready to use unconventional policy as needed. That strikes me as hawkish – the Fed said policy normalization is underway, and they mean it.

Bottom Line: Expect the rate hikes to keep coming. No reason to pause this year. In some sense, expecting a pause even after policy rates hit neutral is more hope than anything else.

Employment Report Up Next

The August Employment situation report is set to be released Friday morning. Most likely it will make little difference for the September FOMC meeting. I am challenged to see an outcome from this report that, in the context of the rest of the data, would forestall a hike at that meeting. And given strong momentum the US economy continues to enjoy, it seems that a December hike remains the baseline case.

Incoming data suggests the labor market remains solid. Employment components in both the manufacturing and non-manufacturing ISM reports both rose in August. Initial unemployment claims remains on a downward trend, falling to a record low with the most recent data. There is no evidence in that number that the tariffs announced to date have materially affected the labor market despite sporadic anecdotal reports of layoffs.

The ADP report estimates private sector payrolls for August of 163k, a bit soft relative to expectations but still enough to push unemployment down further over time. Altogether, the numbers point me to expect an employment gain of 190k tomorrow, pretty much in line with the consensus expectation of 195k in a range of 150k-237k. Note though that Calculated Risk reminds us that August is often below consensus.

To be sure, the Fed will be looking deeper into the report than just the job gains. Unemployment is expected to edge back down to it’s current cycle-low of 3.8%. That is a number that will keep fears of overheating alive, which in turn means ongoing rate hikes. Central bankers will also have their eyes glued to the wage numbers. Weak wage growth remains a mystery for the Fed and that mystery helps keep the rate hikes gradual. I suspect that signs of faster wage growth would rattle the Fed, raising concerns that hey have pushed too far past full employment. The policy implication would be either a faster pace of hikes or a longer period of hikes before the Fed pauses. Still, this has long been a risk and it has long been unrealized.

Looking forward, it appears that the economy holds the momentum of the second quarter. The Atlanta Federal Reserve currently pegs third quarter growth a 4.4%, a figure well, well above the median policymaker’s estimate of long run growth. It would be hard for the Fed to pause in the face of such a number. Support for a pause will grow as policy rates move closer to neutral (current estimates centered on a range of 2.75-3.0%). Until then, policy remains somewhat straightforward, but at that point the tension among Fed policymakers and staff will grow as some push for rates to rise above neutral and others advocate patience.

In Fedspeak today we had New York Federal Reserve President John Williams sticking to a story that supports a gradual pace of rate hikes. He remains willing to invert the yield curve if needed. Via Bloomberg:

“We need to make the right decision based on our analysis of where the economy is, and where it’s heading, in terms of our dual mandate goals,” Williams said Thursday while speaking to reporters after an event in Buffalo, New York. “If that were to require us to move interest rates up to the point where the yield curve was flat or inverted, that would not be something I would find worrisome on its own.”

Reiterating my opinion, an inverted yield curve is almost certain to be the only warning sign when that inversion happens, hence why the Fed tends to ignore that sign. In contrast, St. Louis Federal Reserve President James Bullard places more faith in the recessionary signal of an inverted yield curve. Still, I suspect that he would be in the minority of voting members next year should the yield curve invert. My thinking is that absent an obvious slowdown in the economy or a clear tightening of financial conditions that made a slowdown more than likely, the Fed will tend toward the direction of pushing past neutral even if it threatened or caused an inversion of the yield curve. We don’t have much guidance from Federal Reserve Chair Powell on the conditions for a pause.

Separately, Minneapolis Federal Reserve President Neil Kashkari provides this insight on Fed psychology, via Marketwatch:

There’s scarring from the financial crisis, yes. But there’s scarring, bigger scarring from the inflation of the 1970s. And I think that that is persuading us more than anything else and why we’re so biased towards … you know we say that we are we have a symmetric view of inflation. We don’t mind if it’s 2.1  or 1.9 but in our practice, in what we actually do, we are much more worried about high inflation than we are low inflation. And I think that that is the scar from the 1970s.

Yep, that sounds about right. If there was no threat of the zero lower bound, I think the Fed would have set the inflation target lower at 1.75% compared to 2%. Somewhere deep inside the genetic makeup of you average central banker is a deep aversion to inflation. And that is arguably a desirable quality in a policy maker charged with maintaining price stability. But that same quality has in recent years tend to lead the Fed to tighten maybe just a little too hard and a little too long with the result being no real threat to price stability but two recessions.

Bottom Line: Fed still hasn’t found a reason to pause. The US data isn’t really giving one.  And don’t expect emerging market turmoil to factor much into the Fed’s decisions – until the problem threatens to wash up on US shores, it will fall into the general category of “risks we talk about but don’t act on.”